Netflix May Not Be Worth As Much As You Think

On Wednesday, my Foolish colleague Anders Bylund explained why he thinks that Netflix (NASDAQ: NFLX) may have an intrinsic value above $500 per share. Anders runs through three possible scenarios for Netflix: One is perfection, one is disaster, and one is a middle-of-the-road "likely" case. According to his analysis, Netflix shares could be worth $126 even in a disaster scenario, providing shareholders with a significant cushion in case things go wrong in the future.

However, here at The Motley Fool, we like to indulge opposing opinions. As a Netflix bear, I'd like to explain why Netflix may be worth less than even Anders' worst-case-scenario valuation of $126 per share. Netflix will face two main impediments in the next few years: growing saturation of the domestic streaming market, and rising competition, particularly from Amazon.com's (NASDAQ: AMZN) Prime Instant Video service.

Market sizingIn the past, Netflix CEO Reed Hastings has said he believes the company ultimately has the opportunity to attract between 60 million and 90 million subscribers in the United States. There are around 115 million households in the U.S. today. Assuming only one subscription per household, Netflix has a long-term goal of achieving 50% to 75% household penetration. At the end of 2012, Netflix had more than 27.15 million domestic streaming subscribers, having added roughly 5.5 million subscribers in 2012. In Anders' most pessimistic scenario, Netflix doubles its U.S. membership to 54 million by 2018, slightly below the low end of Netflix's estimated long-term market opportunity.

However, Reed Hastings has admitted that Netflix doesn't have a compelling enough offering today to reach its goal of 60 million to 90 million subscribers. Whereas Netflix's legacy DVD-by-mail offering has a comprehensive catalog, Netflix has been selective when adding content to its online offering. As I wrote in January, the reason for this discrepancy is that the first-sale doctrine gives Netflix significant leverage against content owners in the DVD business. By contrast, streaming content is much more expensive, because Netflix has no alternative to get content aside from signing a licensing agreement. In light of Netflix's limited streaming video selection, it may be unable to generate the universal appeal that would be necessary to penetrate more than 50% of U.S. households.

Eventually, Hastings hopes to overcome this obstacle through the "virtuous cycle." According to this theory, as Netflix's subscriber base grows, the company will be able to expand its content budget, which will allow Netflix to offer additional content and therefore attract new members. However, growing competition, particularly from Amazon, will drive up content prices, making it harder for Netflix to afford a comprehensive content library, even if its total content budget grows.

On the most recent earnings call, Netflix CFO David Wells said customers have become more satisfied with the Netflix streaming offering because consumers have lowered their expectations and now understand that Internet TV services won;t have a comprehensive library like Netflix's DVD service. However, Netflix bulls (and management) need to lower their own expectations. With a less-than-comprehensive content library, Netflix shouldn't expect to reach the same level of household penetration as cable/satellite TV. Time Warner's (NYSE: TWX) HBO, along with its sister station Cinemax, reaches approximately 41 million U.S. subscribers. Netflix, which is moving to a very similar business model (a few original series and a strong but not comprehensive selection of movies), shouldn't expect to grow much beyond that level. Netflix may seem inexpensive at $8 per month, but it also provides much less value than traditional cable or satellite TV, which includes much more content, including first-run TV shows and live sports.

Competition will be a killerNetflix's second major challenge is the fierce competition from Amazon's Prime Instant Video. Amazon has shown a willingness to spend heavily on the Prime Instant Video content library and appears to view Prime Instant Video as a combination of a loyalty program and an advertising program. Prime customers tend to be the biggest Amazon customers, and Amazon is willing to run a loss on Prime subscriptions in order to add more Prime members and increase sales of physical and digital goods.

This creates a serious long-term competitive problem for Netflix. Amazon is essentially an irrational competitor that is willing to run the streaming video business at a loss over the long term. In February 2012, Amazon announced a major streaming agreement with Viacom that brought its streaming library to more than 15,000 videos. A little more than a year later, the Prime Instant Video library has grown by 150% to 38,000 videos, including key deals such as the recent agreement to become the exclusive streaming home of Downton Abbey.

Amazon seems to have outbid Netflix on a number of recent deals. While Netflix's management has shown admirable discipline in not chasing overpriced content, eventually the company will have to put more money on the table to keep its leading position in content or else risk losing market share to Amazon.

Financial impactFor a few quarters, Netflix may be able to grow its streaming contribution margin (18.5% last quarter) by increasing its subscriber count faster than content expenses. Customers won't immediately jump to Amazon even though it's rapidly catching up to Netflix in terms of content quality. However, over the next several years, Amazon's market share will grow as its content quality improves, and Prime Instant Video will compete more seriously with Netflix for users. At the same time, the increase in content costs will prevent Netflix from ever reaching its vision of a "comprehensive" content library, which will make it hard to grow the domestic subscriber base much beyond 40 million.

Cost pressure and slower revenue growth will probably cap Netflix's domestic streaming contribution margin around 20% to 25%, leading to a maximum contribution profit of approximately $1 billion, which doesn't include technology costs, G&A expenses, interest, or taxes. If this scenario comes to fruition, Netflix's domestic streaming business, by far the most valuable part of the company, is worth $2 billion to $3 billion, or $40 to $60 per share. Netflix shareholders could thus be in for a nasty surprise when the long-term growth they expect fails to materialize.

More analysis on NetflixThe precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

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Amazon's Prime streaming interface is still absolutely horrible even with the new beta version. It seems like more of a gimmick to advertise for their expensive non-subscription videos than a legit Netflix alternative.

Conversely, Netflix could offer an a la carte option on top of their subscription service that offers new TV like Amazon and new movies like Vudu, but at a cheaper price than either for their subscribers.

This may not apply all that much to the current stock price of Netflix, but there is plenty of reason for faith in their future. No competitor has shown a quality of service near that of Netflix.

>>I agree that the studios like having Netflix, Amazon, Hulu, etc. out there as an additional income source. However, I still think all the power is in the content owners' hands.

For what it's worth, I think this view misses Netflix's most critical and misunderstood advantage: data.

Amazon doesn't bid irrationally just because it can. It bids irrationally because it has no other choice. A terrible weakness in the crazy economy that governs Hollywood.

Netflix, by contrast, has orders of magnitude more viewing data for not only shows it catalogs now but which used to be inventoried but which now exist elsewhere -- Downton Abbey being a good example.

This isn't like Nielsen. Content owners only get access to viewership data if Netflix chooses to share, and that makes its bargaining position very strong indeed. Certainly much stronger than any of its primary rivals.

NetfliX has gone from 25 + million domestic subs to about 29.5 million domestic in the past 18 months. The amount of latin americans and europeans accessing US accounts via VPN is probably half a million or more, so the anemic growth is probably less than 0% and getting closer to saturation rapidly.

International doesn't have DVDs or as wide a streaming selection and latin america is not english speaking, so you have to temper a lot of anders enthusiasm with cold water. US streaming saturation is about 30 million streaming only, probably 10 million in latin america (and thats a pipe dream considering the broadband, the size of the middle class, language, culture and a whole host of other things). Europe is probably the same as the US, at best. So, we have a top of 70 million- even that is laughable, but lets run the numbers

Thats $8 billion revenue, at least $4.5 billion content, $250 million r&d, $250 million marketing, $300 million g&a, $50 million of interest and $1 billion of income taxes. Thats a peak of $1.65 billion of earnings with a huge gross margin and no competition. That is $294 per share at 10x p/e if they execute perfectly and get extremely lucky.

Reality is they have 1.5 million canadians, 1.5 million british isles, 1 million scandinavians and 1.5 to 2 million in latin america. The growth is horrible 6 months after the massively expensive launches, so it is unlikely that this 6 million will become 9 million. And thete's a reason they chose a marginal market like scandinavia instead of previously advertised spain, or france or germany or italy - big populations where no one wants to sit around watching old American TV shows. Maybe 15 million international and 30 US. So, 5.4 billion revenue, 4 billion content (still a good margin), 700 million marketing and r&d, 275 million g&a , 150 million income taxes, so there's about $300 million net income or about $3 billion realistic market cap about $50 a share, where it will be within the next year. And even that will require fending off competition in the US and mexico when Carlos Slim gets his service.

i agree NFLX is one of the most overpriced companies out there, next to LNKD and Z.

amazon is the biggest competitor, but then you also have blockbuster, redbox, directv...etc, so new competitors will emerge in the states yearly and overseas it is a whole different landscape with competition.

you also dont bring up that your "market" is older people who do not know how to illegally download movies / shows, which most people under 30 do this exclusively instead of paying for services like netflix, so until the torrent sites and newsgroups are all taken down, you will never be able to sign up half the US market due to this

its sad that funds are putting their money into a crazy forward PE with Netflix, there are much more attractive companies, PE's like that should only be warranted when a company has a patent for the next ten years on a new technology, not to a company with a dozen competitors whose product they do make, rather have to negotiate and thus your margin rate can be killed after a negotiation and there goes your stock price

netflix is a $50-$75 / share company, anything over that is FOOOLLLISSHHHHH

@gmaks20: I think you overestimate how many people download movies illegally. I'm under 30, and I know many more people who use Netflix/Prime/Hulu than people who download bootlegs.

@Tim: Maybe I'm just a Luddite, but I don't think the viewer data is worth nearly as much as NFLX claims. Maybe NFLX can optimize its spending better than AMZN, but I don't think it matters when Amazon has much deeper pockets. It can afford to overbid on just about everything. As for penetration, NFLX is closer to a premium TV channel than a pay-TV service. That's the way I think about the addressable market.

@pauldeba: I'm not sure why you think int'l growth is so slow. NFLX added 1.8 million total subs/1.2 million paid subs last quarter; some of that is from the new Nordics market, but most of the growth has to be organic sub adds in the other int'l markets.

You ask me, I think NFLX should try to buy / merge with AMC Networks (or some other comparably sized content producer) rather than trying to go it alone producing content.

Then you have a place for them to "first run" their fresh content like House of Cards. And you get a locked in source of "last season's hits" like Mad Men and Breaking Bad and whatever else AMC has.

It's kind of dumb for them to be throwing away the ad revenue they could be getting for a quality first run show like House of Cards. Giving it to their subscribers first seems like a waste. It's kind of like putting caviar on the Sizzler buffet line. The folks who go to Sizzler will probably eat it up since it's free, but they still won't want to pay any more for their meal.

On the other hand, NFLX is a tough company to short. With their large subscriber base and first mover advantage and high share price they still have a lot of options to fiddle with their business model to save the day. They could start producing more content, buy content libraries, work out revenue sharing "streaming rental" deals, do tiered pricing, etc.

The problem is their current management is a bunch of idiots who continue to doggedly pursue an ill conceived, unsustainable long term strategy. If they ever get their act together, shorts may find themselves in a bad spot. Just look at the AOL / Time Warner merger for an example of a company that turned its overpriced shares into real value.

But I won't be buying shares until I see management pull their heads from their behinds. Hopefully that would include the exit of Mr. Hastings.

If you don't think international growth slows rapidly Look at each quarter starting 9/10 with Canada expansion, 9/11 latin america, 1/12 UK and Ireland, there was renewed campaign in latin america with serious price cutting in brazil after that and then scandinavia in 10/12. There is no doubt that 6-9 months there is deceleration and growth practically dies 12-15 months out.

As far as 900 million pay TV subscribers, I really hope you don't think that netflix will even enter a fraction of those markets. You'd have to be a fool to think they'll enter asia, especially after the disaster in latin america. On top of that, stale old TV shows are a niche, not an industry stalwart

@pauldeba: It's possible that you're right, but at the moment the data is ambiguous at best. 2013 will be a better test since NFLX probably won't enter any new markets until Q4 at the earliest.

@woodfearzme: I agree, except insofar as there are already 27 million people in the US who are paying for the service. Clearly, plenty of people see value in it. On the other hand, when I had a NFLX trial, I didn't see enough content to justify sticking around. The quality of the content will determine how many people are ultimately interested in the service. I suspect that growth will slow rapidly as NFLX approaches 40 million domestic users, but that's really just a guess.

Personally, I like Netflix because it's 'good enough.' I dropped DirecTV because the content didn't match the cost.

When the market died in 2009, we dropped everything except our internet feed and just watched DVD's or what was available off the antenna. We added Netflix after a little while to get a great deal more content than we had.

Sure, content could be better. It could always be better. But it could also be a lot worse. As much as I think Reed Hastings doesn't know how to properly run this company, I'm sticking with them until either their pricing goes up considerably or a competitor actually has a much better product.

Amazon isn't really competition for Netflix. People use Netflix because it is cheap. They can easily justify spending $7.99/month. With Amazon, they have to pay $79/year ($6.59/month). Although it is less than Netflix per month, many people won't even consider Amazon because it looks like it is 10x more expensive than Netflix.

The article above also ONLY talked about domestic streaming. Netflix has been aggressively expanding into international markets. It has only just begun in those other markets where it already has a presence, and so Netflix has a huge number of new users it can reach. It clearly has a lot of work to do in those markets, and I think it remains to be seen what will happen with them. I'm not sure whether the content deals they have in place for domestic customers allow them to share that with the other markets or not, but if they do, then I think these other markets give Netflix a pretty big advantage, potentially. (Again, I don't know to what extent Amazon or any other comptetitors are working on those other markets, so I could be mistaken there.) Also, I agree with one of the previous posts that Netflix's UI is miles ahead of Amazon's, and I think Netflix is much better about helping customers find content that they would enjoy watching. And I also agree that Netflix has much more data and a much better handle on what content is worth than the others, so they don't overspend.

It is an interesting point that you make about Amazon being essentially an "irrational competitor", although I don't think of it as being irrational at all. It's called having deeper pockets, and being willing, at least in the short term, to take losses in order to get customers in the door (loss leaders). Amazon offers a whole lot of other products that Netflix doesn't. I love being able to have stuff shipped to my house via 2nd Day Air for free. To me it is well worth the cost of Prime given all that I get for that money. So far as video streaming, we spend far more time watching Netflix content than Amazon content, but I sure do like being able to watch shows for free on Amazon (when I can find ones that I like) for free. And occasionally, we'll even pay for certain shows on Amazon Instant Video. I think that's also another "advantage" that Amazon has over Netflix--if the movie you're looking for isn't one of the "free" ones included with Prime, they will usually still let you watch it as "pay-per-view". In some cases, you can even "buy" the content--adding it to your own library, which means you can then watch it whenever you want. Netflix might do well to look into such an offering, although they might have decided against any such thing on principle (all content should be included).

@programinator: I don't think Amazon is necessarily irrational on a global scale. My point is that its actions in the streaming video market specifically are probably irrational when viewed in isolation from the rest of the company. In other words, Amazon can run the streaming video as a loss leader over the long term.

Right now, Amazon is still behind Netflix in terms of UI and content. It may catch up on the UI, and I definitely expect it to catch up in content within the next year or two. At that point, I think some customers who have both may think about dropping Netflix (since Prime provides other benefits), and people new to the streaming video market will not automatically choose NFLX.

As for international markets, I seriously doubt that they will ever be as profitable as the U.S. market. The content deals are separate for the most part: companies are paying for content by region. That's why the international markets are losing hundreds of millions of dollars a year: NFLX doesn't have enough subscribers yet to cover its content costs. Also, Amazon has a much stronger footprint in Europe relative to Netflix, through its LOVEFiLM service.

You're absolutely right, Tim. I think that original content (and to a lesser extent, exclusive content) is necessary to create long-term differentiation. The question is whether Netflix can afford to create enough original content to justify the subscription while also improving its selection of 3P content. I'm skeptical.

The "vision" of the Netflix DVD-by-mail service made sense to me: the goal was to have "everything" available with fast delivery at a reasonable price. I don't think the streaming video service has the same kind of vision. It seems to be aiming to have enough content and "different" content at an attractive price.

As far as the irrationality of Amazon, it will only matter to Netflix if Amazon is willing to pay the extra for exclusive streaming rights over huge libraries of material and then include it all in the Prime subscription. That does not seem to be Amazon's business plan at all.

I am originally from India, over there the Internet is usually slower and much more expensive than in the US. Plus, most people simply download bootlegged content from the Net whenever they want to watch foreign (and even Indian) films. I have never heard anyone paying for content online.

Even now, you rarely see anyone using original WIndows or Office versions over there. I don't see how that will be any different for streaming.

I am assuming this problem will be there in other Asian countries too.

@kingster2013: I think you are probably right about the difficulty of penetrating most Asian markets. Bootlegging seems to be a much more widespread practice there. Not very surprising, since $100 a year for a service like Netflix would be a huge imposition on many people in India, China, Indonesia, etc.